Financial Chore #3: Consolidate Your Debt

This post is the third in my series on knocking out chores to get your financial house in order. The series starts here.

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What’s the best way to consolidate my debt?

Should I try debt consolidation?

Where can I get a debt consolidation loan?

It's one of the most common questions I get, and I understand why.

It's not unusual for someone in debt to be making five to eight payments each month just to credit card companies. In that sense, debt is a lot like clutter. Even when you manage to get all those payments made on time each month, it takes an enormous amount of mental and physical energy just to keep up.

Cleaning up that debt by consolidating it can make things a lot easier. DebtConsolidationCare.com, which offers free advice to consumers with debt consolidation questions along with a free debt consolidation calculator, lists eight benefits of debt consolidation, including a single monthly payment, reduction of interest, and stopping collection calls.

All of those benefits lead up to the ultimate goal, however, which is to get out of debt. Rearranging all that debt does no good if you don't eventually get rid of it.

I’ll describe several debt consolidation options in a moment, but before I do, I'd like you to ask yourself three things:

1. How much do I owe? It sounds like an obvious question, but you’d be surprised how easy it is to lose track of the totals when you’re overwhelmed financially.

2. How strong is my credit score? Some consolidation methods will affect your credit scores more than others. Before you start, you need to be realistic about where your credit stands now. Don’t assume that it's strong because you are making your monthly payments on time. Read my previous post on how to get your credit reports and scores from Equifax, Experian and TransUnion .

3. How motivated am I really to get out of debt? This is an important question. Some people will do whatever it takes, while others aren’t willing to go to extremes. If you have a partner, he or she has to be on board with you. At a minimum, you’ll have to follow a basic budget.

Once you’ve answered these questions honestly, the next step is to look at the options. Since this is a blog post, and not a debt consolidation book, I am keeping it brief here. You can get more details, including help with your individual questions, at DebtConsolidationCare.com.

Debt Consolidation Loan

Get a loan and use it to pay off all your other debts, then make one monthly payment to your new lender. Ideal right? The problem is, the more you need a consolidation loan, the harder it is to get one. Many banks don’t even make small unsecured consolidation loans anymore.

You may need to turn instead to a P2P or social lending service. My colleague Beverly Harzog, who co-authored The Complete Idiot’s Guide to Person-to-Person Lending with Curtis Arnold, reports that peer-to-peer lending is making a comeback, but you’ll likely need excellent credit to qualify. (You checked your scores, right?)

A friend or relative may be willing to give you a consolidation loan, but take the initiative to write up a loan agreement and take it seriously. Otherwise, just be honest about your situation and ask for a gift.

The downside: If you are able to get a debt consolidation loan at a decent rate, it may be easy to fall into the trap of using the credit cards again. And if you don’t stick with a spending plan, the consolidation loan will soon become just another monthly payment.

Credit Counseling

If you enroll in a Debt Management Program (DMP) with a credit counseling agency you’ll make one monthly payment to the counseling agency which will in turn pay each of your participating creditors. You’ll be out of debt in five years or less.

The downside? You’ll close all your credit cards, and that will affect your credit scores (though not as much as you may expect). The biggest challenge will be to stick with the payment schedule each month or you could wind up falling out of the program and starting all over again.

Loans Against Retirement Plans

Borrow the money you need to consolidate from your 401(k), 403(b) or pension plan. (You cannot borrow against an IRA.) No credit check is required. You’ll pay it back to your own retirement account. That means the interest you pay will, in effect, be to yourself.

The downside: The total monthly payments over 60 months (the maximum term for one of these loans) may be close to or higher than the amount you’re paying on your credit cards. That means you may find yourself turning back to the plastic again when money is tight. If you leave or lose your job, you may have to pay it back immediately or take the balance as an early withdrawal, which means you have to pay taxes and a 10% penalty. The same thing can happen if you can't keep up with the payments.

Other alternatives to debt consolidation:

If the above options don't work for you, you may have to get a little more creative.

DIY Consolidation: Your credit card statements list a dollar amount you must pay each month to pay off your balance in three years. Set up automatic withdrawals from your bank account for that amount, and put your credit cards away so you can’t use them. If you get any extra money – a tax refund for example – throw it at your debt with the highest interest rate. You’ll be debt-free in three years or less.

Bankruptcy: While it may seem like the most drastic step, sometimes it’s necessary. Just don’t wait until you are about to lose your house or have drained all your retirement savings to talk with a bankruptcy attorney.

Have you consolidated debt successfully – or not so successfully? I’d love to hear from you. Use the comments section below to share your story.

In 1987 I "fell" into a job working for a small consumer advocacy group in Washington DC. (I thought I wanted to be a banker...really!) Since then, I've been trying to help people find reliable answers to their credit questions. That's what makes me tick. I've written or co...

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